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Managerial Finance
MB-664
Economic Concept Overview
MB 664 UVG-TAMU May 2009
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Today’s Decision Climate
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Global economy
Little or no information lags
Sources of risk in making decisions
Decisions at the enterprise level
Decisions related to expansion
Importance of quality information in
making decisions
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Market Forces
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Expected Commodity Price
$7
D
S
D = f(Po, PYD, Px, W, …)
D=S
$4
S = f(Po, MIC, …)
$1
10
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Implications for the Firm
Price
The Firm
The Market
D
S
Price
ATC
MC
PE
QE
Quantity
MB 664 UVG-TAMU May 2009
OMAX
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Implications for the Firm
Price
The Firm
The Market
D
S
Price
ATC
MC
PE
Profit
QE
Quantity
MB 664 UVG-TAMU May 2009
OMAX
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Knowing Your Elasticities
• Market demand
related elasticities
• Market supply
related elasticities
• Concept of price
flexibility
• Application and
implications
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Inelastic Market Demand
Price
%∆P>%∆Q
Elastic Market Demand
Price
%∆P<%∆Q
∆P
∆P
Identical shift
in the supply
curve
∆Q
Quantity
MB 664 UVG-TAMU May 2009
∆Q
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Concept of Price Flexibility
Price
EP = - .25
If the own price elasticity of
demand is equal to .25, then
PF = 1/-.25 = -4.0
-4%
+1%
Quantity
This means that if the
supply coming onto the
market is expected to
increase by one percent,
the price you can expect to
receive for your products
will fall by 4 percent.
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Short Run Input Decisions
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Input Decision for Variable Inputs
D
C
B
E
F
G
5
H
I
J
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Least Cost Decision Rule
This
decision
rule holds
a larger
The
least
cost combination
of labor for
and capital
in
out
example also
occurs where:
number
of inputs
as well…
MPPLABOR ÷ wage rate = MPPCAPITAL ÷ rental rate
MPP per dollar
spent on labor
=
MPP per dollar
spent on capital
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Least Cost Input Choice for 100 Units
7
60
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What Happens if Wage Rate Declines?
As a consequence,
the firm would
desire to use more
labor and less
capital…
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What Inputs to Use for a Specific Budget?
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Short Run Enterprise Decisions
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Combination of Products
The profit maximizing combination of two products is
found where the slope of the production possibilities
frontier (PPF) is equal to the slope of the iso-revenue curve,
or where:
Canned fruit
Canned vegetables
Slope of an
PPF curve
Price of vegetables
= – Price of fruit
Slope of isorevenue line
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Profit Maximization Product Choice
Output combinations
lying beyond the PPF
exceed the firm’s
existing capacity. The
firm would have to
expand its capacity
and labor force to
achieve this output.
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Profit Maximization Product Choice
Canned fruit
Canned vegetables
= –
Price of vegetables
Price of fruit
Shifting line AB out in
a parallel fashion
holds both prices
constant at their
current level
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Profit Maximization Product Choice
The firm would shift from point
M on the PPF to point N as a
result of the decline in the price
of fruit. That is, to maximize
profit, the firm would cut back
its production of canned fruit
and produce more canned
vegetables.
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Long Run Capacity Decisions
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Growth of the firm…How much should we expand?
Is this firm size earning a profit?
Page 17 in
booklet
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Growth of the firm…How much should we expand?
No. Its average cost exceeds its
average revenue at price P. The
firm therefore must either
expand or cease operation. How
much should it expand?
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Growth of the firm…How much should we expand?
Firm size 2, 3 and 4
would earn a profit
at price P….
Q3
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Growth of the firm…How much should we expand?
Q3
At size #2, the firm’s
profit would be the
green area shown
above…
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Growth of the firm…How much should we expand?
Q3
At size #3, the firm’s
profit would be the area
shown above…
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Growth of the firm…How much should we expand?
At size #4, the firm’s
profit would be the area
shown above…
Q3
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Growth of the firm…How much should we expand?
If price were to fall to
PLR, only size 3 would
not lose money; it
would break-even.
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Growth of the firm…How much should we expand?
Expansion to size #4
runs the risk of having
to downsize or idle part
of its existing capacity
if the industry settled
at price PLR
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Expanding the Firm’s Capacity
Page 19 in
booklet
Optimal input
combination
for output=10
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Expanding the Firm’s Capacity
Two options if doubling output:
1. Point B ?
2. Point C?
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Expanding the Firm’s Capacity
Optimal input
combination
for output=20
with budget FG
Optimal input
combination
for output=10
with budget DE
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Expanding the Firm’s Capacity
This combination
costs more to
produce 20 units
of output since
budget HI exceeds
budget FG
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Expanding the Firm’s Capacity
Growth expansion path
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Capacity Concepts
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Definitions
 Engineering capacity – maximum output for which
enterprise was designed
 Economic capacity – output given economic objectives
and normal operating policy
 Capacity utilization rate – ratio of actual output to
engineering capacity
 Capacity efficiency rate – ratio of actual output to
economic capacity
 Desired utilization rate – ratio of economic to
engineering capacity
 Bottleneck – constraint on economic capacity
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Concept of Capacity Utilization at Market Level
Price
S1
Engineering
capacity
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Concept of Capacity Utilization at Market Level
Price
S1
D1
P1
Economic Engineering
capacity
capacity
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Concept of Capacity Utilization at Market Level
Price
S2
S1
D1
P1
Actual
output
Economic Engineering
capacity
capacity
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Concept of Capacity Utilization at Market Level
Price
S2
S1
D1
P2
P1
Actual
output
Economic Engineering
capacity
capacity
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Concept of Capacity Utilization at Market Level
Price
S2
S1
D1
P2
Bottleneck
P1
Actual
output
Economic Engineering
capacity
capacity
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Market Price/Quantity
Relationships
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Stochastic Relationship Between Output and Price
An example of
potential market
outcomes
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An interpretation
of potential price
variability
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Pro Forma Analysis of Future Trends
Weekly Closing Price Volitility
6-Jul
13-Jul
20-Jul
27-Jul
3-Aug
10-Aug
17-Aug
24-Aug
31-Aug
6-Sep
16-Sep
23-Sep
30-Sep
5-Oct
12-Oct
19-Oct
26-Oct
2-Nov
9-Nov
16-Nov
23-Nov
30-Nov
7-Dec
14-Dec
21-Dec
28-Dec
4-Jan
11-Jan
18-Jan
25-Jan
1-Feb
8-Feb
15-Feb
22-Feb
29-Feb
7-Mar
14-Mar
20-Mar
30-Mar
4-Apr
11-Apr
18-Apr
25-Apr
$6.25
$6.00
$5.75
$5.50
$5.25
$5.00
$4.75
$4.50
$4.25
$4.00
$3.75
$3.50
May 2008 Contract
July 2008 Contract
A necessary element to evaluating
potential investment alternatives.
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Evaluation Methods
Stochastic analysis of commodity
prices and unit input costs
Risk and required rates of return
Risk adjusted capital budgeting
Pro forma financial statement analysis
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